Notes on Hayek's Individualism and Economic Order

These are my notes on Friedrich Hayek's Individualism and Economic Order for an economics project in college.

Equilibrium refers to actions. "All propositions of equilibrium analysis, such as the proposition that relative values will correspond to relative costs, or that a person will equalize the marginal returns of any one factor in its different uses, are propositions about the relations between actions." (p. 36) Thus equilibrium assumes a span of time "since the actions of one person must take place successively in time." (p. 37)

Only actions can be in equilibrium, not a person or thing such as a market. A single person's actions can be said to be in equilibrium as far as they are part of a single plan. Such actions must be based on the same expectations (expected values of the data). The data are as known by the acting individual, not objective facts as the observing economist knows them.

For the actions of many individuals to be in equilibrium, all individuals must have the same knowledge and expectations of the data (else their plans will conflict and at least some will require changes), and the individuals' plans must be compatible (that is, because one's actions are another's data, each person's plans must be known and expected by others).

Change or constancy in data refers to the subjective knowledge of acting individuals, not to objective change or constancy. For example, if the sun stopped moving across the sky, objectively there is an absence of change but there is obviously change in economic data requiring revision of plans.

The equivalence of every individual's subjective interpretation of the data and the correspondence of this interpretation to objective reality (that is, expectations proving correct) are not preconditions to equilibrium but its defining characteristics.

Economists study equilibrium because they believe a tendency towards equilibrium exists in reality. This can only mean that there exists a tendency for the knowledge of different individuals to become both uniform and correct, which is an empirically testable proposition. Study of equilibrium cannot however determine the conditions necessary for this tendency or the process by which it occurs.

Most economic anlaysis consists of tautological, logical deduction from assumptions. The conclusions of such analysis are valid only when the assumptions are present. The existence of the assumptions is the point at which economics is verifiable. The analysis itself can be tested only for logical consistency.

One of the conditions often considered necessary for the tendency towards equilibrium is 'constancy of the data.' This can not mean that nothing that can affect economic decisions ever changes objectively, which would imply that the sun never moves and so forth. What is usually meant is that "there must be some discernible regularity in the world which makes it possible to predict events correctly." (p. 49)

Individuals need not possess perfect knowledge of everything for their actions to be in equilibrium. The only knowledge that must be correct is knowledge which "will necessarily be confirmed or corrected in the course of the execution of the plan." (p. 53) Knowledge may exist which would affect an individual's plans, but be unknown to the individual, and still the individual's plans can be compatible with everyone else's. Equilibrium in the simplest view is not necessarily an optimum position.

Things defined by the social sciences "refer not to some objective properties possessed by the things, but to views which some other person holds about the things." Such definitions are independent of physical properties. They can be defined only in reference to a person, a goal of the person, and a thing the person believes to be a means to the end. Money can not be defined in terms of shape or substance, but only in terms of the beliefs of some person or people.

Facts of the social sciences are either such definitions or human action itself. Actions are grouped together as the same thing not because of their physical properties but because of the actors' intentions.

Such definitions imply attitudes or intentions on the part of people, and can be understood by the scientist only "on the analogy of our own mind." (p. 63) The action is what it is, and not simply physical motion, because we believe the actor has a specific intention. Because action can be known only through analogy with our own mind, our mind can construct through pure logical deduction "an (at least in principle) exhaustive classification of all the possible forms of intelligible behavior." (p. 68) Economics does not explain action (the realm of psychology) but classifies and orders it.

Economic actions are "all acts of choice which are made necessary by the scarcity of means available for our ends." (p. 68)

Facts about social collectives can not be observed. A historical fact is not a single entity, but a composite of many parts selected on the basis of a prior understanding (theory) of what such a fact is. For example, the American Revolution is not a single observable fact but a selection of specific actions, places and times, all selected according to a theory of what constitutes a revolution. The historian uses theory to determine the relevant parts of the whole. Theories of social collectives are not about the collectives but constitute them. They "provide schemes of structural relationships ... [that] fit together into a meaningful whole the elements which he [the historian] actually finds." (p. 72) Social theories therefore can "never be verified or falsified by reference to facts. All that we can and must verify is the presence of our assumptions in the particular case." (p. 73)

The 'economic problem' is how to make the best use of available means. "If we possess all the relevant information, if we can start out from a given system of preferences, and if we command complete knowledge of available means, the problem which remains is purely one of logic ... This, however, is emphatically not the economic problem which society faces." (p. 77)

The knowledge necessary for the solution of the economic problem is never concentrated in a single mind, and part of the problem is how to utilize knowledge which is scattered among many individuals. Much of the knowledge needed is not scientific knowledge but "knowledge of the particular circumstances of time and place." (p. 80)

Each individual possesses some of this local knowledge, but needs knowledge from other areas beyond his scope to make decisions. Prices convey the necessary information -- how scare each means is relative to other means, and changes in this relative scarcity. "Prices can act to co-ordinate the separate actions of different people in the same way as subjective values help the individual to co-ordinate the parts of his own plan." (p. 85)

The theory of perfect competition assumes conditions that true competition brings about. The theory generally assumes the following conditions:

  1. A homogeneous commodity offered and demanded by a large number of relatively small buyers and sellers, none of whom expects to exercise by his action a perceptible influence on price.
  2. Free entry into the market and absence of other restraints on the movement of prices and resources.
  3. Complete knowledge of the relevant factors on the part of all participants in the market.

(p. 95)

With the last assumption, producers "are assumed to know the lowest cost at which the commodity can be produced." (p. 95) Producers are also assumed to know consumer demand already. "These cannot properly be regarded as given facts but ought to be regarded as problems to be solved by the process of competition." (p. 96)

Some goods and especially services are inherently different from each other, which in equilibrium models represents 'imperfect' competition. Product differentiation can be the result of the nature of the good itself, and have nothing to do with competition. Further, considering homogeneousness always superior to differentiation implies that variety has no value.

The grouping of commodities into classes as the 'same' product is an arbitrary construction. Reality is closer to the case in which no product is exactly like another. In such a case competition would still "bring about a set of prices at which each commodity sold jsut cheap enough to outbid its potential close substitutes." (p. 100) Competition should not be compared to some ideal but to "the situation as it would exist if competition were prevented from operating." (p. 100)

Knowledge is diffused among individuals, and those who possess relevant knowledge must be persuaded to do so. Profits provide the incentive and competition the means to use knowledge.

In markets which approximate the conditions of 'perfect' competition (that is, where product and production are standardized), competition is absent because it is not needed. When the data changes, it is competition which distributes the new knowledge and returns the market to its 'stable' state. "Competition is more important the more complex or 'imperfect' are the objective conditions in which it has to operate." (p. 103)

"There is no sense ... in discussing what somebody with perfect knowledge would do if our task must be to make the best use of the knowledge the existing people have." (p. 104)

Competition produces the best use of available resources when not restricted by government. A government-enforced monopoly is inefficient not because price is higher than cost but because costs are probably higher than necessary. A monopoly based on efficiency is as beneficial as a more obviously competitive market, because the market position can and will be taken away by firms with knowledge of more efficient production.

An implicit assumption of all models of the market is the existence of a legal framework. "That a functioning market presupposes not only prevention of violence and fraud but the protection of certain rights, such as property, and the enforcement of contracts, is always taken for granted." (p. 111)